A Mythical Beast Has Risen to Provide a Long Trade Opportunity

You can invest in the US financial sector, which has historically been the best performing area of the U.S. equity market during a three-headed U.S. hydra economic environment, via the Financial Select Sector SPDR Fund (XLF), suggests Landon Whaley of Focus Market Trader.

A man known simply as Rumi said some of the most profound things I’ve ever read. No, I’m not talking about Beyoncé’s baby: Rumi was a 13th century poet, and he managed more memorable one-liners than a Vince Vaughn flick.

One of my favorite Rumi quotes is “The art of knowing is knowing what to ignore.” Rumi would have made one hell of a global macro trader because that 800-year-old quote succinctly sums up the key to successful investing.

It’s critical to ignore the plethora of distractions the markets and media send your way and focus your attention on only the most critical developments.

Over the last month, the most critical developments have occurred in Cleveland, Ohio and in two specific U.S. markets. These developments are speaking loudly as we begin the final three-month push of 2017.

What not to ignore

Recently, in Cleveland Janet Yellen gave us great insight into the Fed’s next move.

The core topic of Yellen’s most recent public comments was the surprisingly low level of inflation the U.S. has experienced most of this year. She flat out said, “the shortfall of inflation this year is more of a mystery.” How’s that for intellectual honesty?

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The real juice came when Yellen said, “[There are] considerable odds that inflation won’t stabilize at 2% over the next few years” and “[it] would be imprudent to leave rates on hold until inflation reaches 2%.”

Allow me to translate “Fed speak.”

The Fed chairperson just told us they are raising rates in December and will begin shrinking the balance sheet as planned. She also revealed the Fed is no longer data dependent, but they have rather become market dependent. Specifically, the Fed is making decisions based on a healthy labor market that continues to create jobs and a healthy stock market that continues to create brand new all-time highs.

The bottom line is the Fed is moving forward with normalization, low inflation be damned.

A Fed chair whispering hawkish sentiment in our ears coupled with more rate hikes and a reduction in the Fed’s balance sheet is not what investors are positioned for right now, and it’s going to catch a lot of people wrong-footed.

The beast has risen

As we enter Q4, U.S. economic growth continues to accelerate, but now we have something else occurring in markets that we haven’t seen in almost a year. In addition to improving U.S. growth, we now have a rally in the U.S. dollar and U.S. yields.

Around the office, we call that the three-headed U.S. hydra because, just like the mythical beast, when it rises out of the Lake of Lerna, its impact is felt far and wide.

On September 8, the U.S. dollar finally bottomed and has now gained in four consecutive weeks. But the greenback isn’t the only U.S. market benefiting from strong U.S. economic data and hawkish Fed rhetoric; U.S. yields have found their footing again as well. After languishing for most of the year, two-year Treasury yields have spiked to the highest level since the crisis, and 10-year yields are now trading at three-month highs.

When these three factors move higher in lockstep, the playbook is straightforward. You want to be involved in the financial and technology sectors of the U.S. equity market, and you want to avoid gold, bonds and their equity cousins (utilities and REITs).

The last time we experienced the three-headed U.S. hydra was the final six months of 2016. During that time, long-dated Treasuries lost 13.8%, gold lost 13.3% and utilities lost 5.8%. On the flipside, U.S. tech stocks gained 12.5% and financials gained 26.5%. How’s that for some outperformance?!

But it’s not just performance that is impacted by the hydra. Risk for certain markets gets amped up as well. In fact, Treasuries, gold and utilities exhibited nearly three times as much downside risk as U.S. tech and financial stocks during that stretch.

Wrong-Footed

The three-headed U.S. hydra has been rising for the last four weeks and asset classes are reacting exactly as we would expect.

Long-dated Treasuries have lost 3.3%, gold is down 5.0% and utilities have declined 3.4%. Once again, tech and financial stocks have been rallying, gaining 2.2% and 7.7% respectively.

Despite the playbook being clear, investors are positioned long in both Treasuries and gold. Not only that but during September they added an additional $258MM to the largest U.S. utility exchange-traded fund, the Utilities SPDR ETF (XLU).

They also have the lowest long Nasdaq exposure in the last year despite technology being one of the best performing sectors in this type of environment.

And if all that positioning data wasn’t enough to convince you that investors are completely unaware of the hydra, they are also betting against the Russell 2000 index. But why does that matter?

It matters because the Russell 2000 (RUT), a U.S. small cap index, is heavily weighted towards financial stocks, which is why it gained 6.7% during September. This is not the environment in which to short financial stocks of any size!

The bottom line

In the investing game, success depends upon focusing your attention on the critical economic and central bank developments and knowing what to ignore.

The Fed is crystal clear in their hawkish intentions, U.S. economic data is clear in its signal of accelerating growth, and the greenback and U.S. yields have clearly bottomed.

There is a right way and a wrong way to be positioned when the U.S. three-headed hydra arises. Fortunately for you and I, most investors have not mastered “the art of knowing.”

The long trade idea

You can invest in the U.S. financial sector, which has historically been the best performing area of the U.S. equity market during a three-headed U.S. hydra economic environment, via the Financial Select Sector SPDR Fund (XLF).

As long as XLF trades above $24.18, then you can use any weakness to initiate new long trades.

Depending on where you enter the trade and how much room to move you want to give this trade, you can use a risk price between $25.03 and $24.18.

That said, your risk price line in the sand is $24.18, if XLF closes below that price, then you should exit any open trades.

If the trade moves in your favor, I would book profits on any rally to the $26.42 to $27.17 range.